Shivani RawatSenior Associate
Until recently, the enforceability of put options and foreign awards upholding the investor’s exercise of a put option remained a grey area under Indian law.
From a regulatory perspective, put options in public companies were considered invalid under the Securities Contract Regulation Act, 1956 (SCRA) because they did not fall within the definition of spot delivery contracts or derivative contracts. Put options were also considered speculative since the right to exercise them depended on future events. In the context of the Foreign Exchange Management Act, 1999 (FEMA), put options providing returns at a pre-determined rate to investors were viewed as violating guidelines that prohibited guaranteed returns on investments.
These issues assumed greater significance when foreign investors opting to exercise put options as the preferred mode of exiting their investments in Indian companies, met with resistance from shareholders based on the legal and regulatory uncertainty surrounding put options. Once disputes arose, the shareholders often resorted to the defence of put options violating SCRA and FEMA. They challenged the enforcement of foreign awards upholding put options, arguing that such awards were contrary to the fundamental policy of Indian law since they breached Indian law.
However, recent decisions of the Supreme Court of India and various High Courts rendered in the context of enforcing foreign awards upholding the exercise of put options have substantially answered these challenges.
Recent developments in the judicial position
In the 2020 seminal decision of Vijay Karia v Prysmian Cavi E Sistemi SRL, the Supreme Court held that transactions that violate FEMA were not void. Therefore, any award upholding such a transaction could not be invalidated on this ground. While holding so, the Supreme Court dismissed the challenge to a foreign award that had upheld the sale of shares in an Indian company to a non-resident entity at a discounted price and rejected arguments that such a sale breached the FEMA (Non-Debt Instrument) Rules, 2019. Crucially, the Supreme Court recognised that post-facto approval of such transactions could always be sought from the sectoral regulator, the Reserve Bank of India. The Supreme Court also affirmed the larger principle expounded in the Delhi High Court’s 2017 decision of Cruz City 1 Mauritius Holdings v Unitech Limited, that mere breach of a statutory provision was insufficient to refuse the enforcement of a foreign award.
Echoing the views in Vijay Karia and Cruz City, in the 2020 decision of Banyan Tree Growth L.L.C v Axiom Cordages Limited and Ors., the Bombay High Court also analysed the put option against the statutory backdrop of SCRA and the parties’ contractual arrangement. On a holistic construction of SCRA and related notifications that permitted securities transactions through spot delivery contracts, the Court rejected the implication that put options under share subscription agreements were prohibited or could be categorised as speculative transactions. On the subject of spot delivery contracts, the Court agreed with the 2019 decision of Edelweiss Financial Services Ltd. v Percept Finserve Pvt. Ltd. In Edelweiss, the Bombay High Court had upheld the exercise of a put option on the basis that it was a spot delivery contract under SCRA, given the near-simultaneous exchange of shares and payment. An appeal against the Banyan Tree decision was dismissed with exemplary costs by the Supreme Court, signifying a clear intention to discourage parties from reneging on their contractual obligations.
In yet another emphatic endorsement of the enforceability of awards upholding put options, the Calcutta High Court and Supreme Court recently dismissed the challenge to the foreign award in the case of EIG (Mauritius) Limited (EIG) v McNally Bharat Engineering Company Limited (MBECL).
The Calcutta High Court’s decision in EIG (Mauritius) Limited
In November 2021, the Calcutta High Court dismissed a challenge to the enforcement of the foreign award dated 19 June 2020 (Award), granting EIG damages for the breach of a put option by MBECL (the resident shareholder). The arbitration was seated in Singapore and conducted under the ICC Rules, 2017. The damages (the loss suffered by EIG because of the put option breach) equalled the value of EIG’s investment in McNally Sayaji Engineering Limited (Investee Company) plus a 22% compounded annual rate of return on the investment.
Crucially, in EIG’s case, the put option clause in the shareholders’ agreement obligated MBECL ‘if legally able or otherwise to arrange for a third party to purchase’, at EIG’s option, all or a portion of EIG’s shareholding in Investee Company at the agreed price. EIG’s put right was triggered by MBECL’s failure to provide EIG with an exit from its investment. Upon EIG exercising this right, MBECL refused to honour the put option alleging that the put option was illegal because it contravened SCRA and FEMA.
The Court’s reasoning
Mindful of the proscription against examining the merits of a foreign award under challenge, the Court analysed two key issues:
Whether the threshold of the enforcement of the Award breaching the fundamental policy of Indian law was met?
As a first step, the Court noted the narrow scope of the public policy defence, which signified that something more than mere contravention of law was necessary for any judicial intervention in enforcing a foreign award. This principle was settled by the Supreme Court’s landmark 1994 decision in Renusagar Power Co. Ltd. v General Electric Co. The principle was refined further and applied to violations of FEMA in Cruz City (as approved in Vijay Karia), holding that contravention of a legal provision was not synonymous with contravention of the fundamental policy of Indian law. Following from this, the Court held that FEMA does not form part of the fundamental policy of Indian law. Therefore, even if it was assumed to have occurred, a mere violation of FEMA would not render the Award unenforceable.
Whether the Arbitral Tribunal’s decision on matters of contractual and legal interpretation could be questioned?
In the second stage of its enquiry, the Court examined if the Arbitral Tribunal had reasonably concluded that the put option did not violate (i) SCRA since it was a spot delivery contract; and (ii) FEMA because MBECL had to arrange a non-resident third party to purchase the shares if it was legally unable to do so itself, and FEMA did not apply to transactions between non-residents (EIG and the non-resident third party purchaser).
Regarding the SCRA objection, the Court noted that the contract required an immediate transfer of shares by EIG to either MBECL or a third-party purchaser nominated by it upon payment of the put option price to EIG. Accordingly, the Arbitral Tribunal’s construction that the put option was indeed a spot delivery contract was in line with the commercial purpose of the transaction and the parties’ intention at the time of executing the contract. This interpretation also accorded with Edelweiss, which had been affirmed in Banyan Tree.
Regarding the FEMA objection, the Court observed that the Arbitral Tribunal had examined the parties’ differing interpretation of the obligations under the contract and found no fault with the Arbitral Tribunal’s reasoning that ‘legally able’ referred to MBECL’s legal ability to complete the put option. If MBECL was legally unable to purchase the shares from EIG (because of FEMA restrictions), the third party must include a non-resident third party to which FEMA would not apply. This view has further clarified the 2017 decision in NTT Docomo Inc. v Tata Sons Ltd. NTT Docomo, which held that FEMA restrictions would not have applied if the promoter (Tata Sons Ltd.) had performed its obligation to find a non-resident buyer for Docomo’s shares in the investee company.
The recent decision in EIG (Mauritius) Limited brings further clarity to the enforcement of exit mechanisms structured to provide assured returns, offering much-needed comfort to foreign investors.
The appeal to the Supreme Court was dismissed on the first hearing, fortifying the pro-investor and pro-enforcement approach demonstrated in EIG (Mauritius) Limited and signalling the primacy accorded to contractual intention.
MBECL’s challenge to the Award before the Singapore International Commercial Court was also dismissed on similar grounds, reinforcing the consistent position of Singapore Courts that the public policy ground for challenging awards is narrow and courts should refrain from opening up a tribunal’s findings.
Trilegal represented EIG in Singapore seated arbitration and the subsequent proceedings before the Calcutta High Court and the Supreme Court. It also represented EIG in MBECL’s challenge to the Award before the Singapore International Commercial Court.
The path ahead
The doubts around enforcement of awards that upheld put options, has been a concern for foreign investors who may have or may wish to opt for put options as a mode of exit. The recent decision in EIG (Mauritius) Limited brings further clarity to the enforcement of exit mechanisms structured to provide assured returns, offering much-needed comfort to foreign investors.
That said, it remains important to ensure that put option clauses are unambiguous and watertight. Investors should ensure that the obligation to provide the exit is absolute and not conditional. To avoid defences premised on FEMA, investors can consider structuring the put option clauses to require shareholders to procure non-resident third party purchasers as a fallback option, to benefit from the Docomo and EIG (Mauritius) Limited decisions. Care should also be taken to ensure that share transfer mechanism is compliant with the SCRA.
Recent decisions of the Supreme Court of India and various High Courts rendered in the context of enforcing foreign awards upholding the exercise of put options have substantially answered these challenges.